Debt's surprising silver lining

"Opportunity often comes disguised in the form of misfortune, or temporary defeat"
– Napoleon Hill

Your cloud of debt has a silver lining.
Do you have trouble believing that statement? It may depend on the current status of your relationship with debt. Perhaps it's way too involved, and your debt hovers over you like a dark cloud. If that's the case, the information in this post will help you.

Alternatively, you may be farther along on your journey towards financial freedom. Your debt levels are under control, maybe you don't owe anyone anything. If so, that's fantastic, but I encourage you to keep reading! You can always use this information to help others; colleagues, friends or family members who may be struggling to manage their debt.

Where's the FIRE?
If you've spent any length of time reading personal finance blogs, you've heard of the FIRE concept. The idea that by achieving Financial Independence, any person has the ability to Retire Early.

There are lot's of FIRE guru's out there, with the message that early retirement is attainable for anyone. The key, however, is to understand your 'savings rate'.

Here's how it works.

Simply put, the percentage of your net income you are able to invest in long term savings determines how many years it will take you to retire. The formula holds true regardless of your income level.

An example:

-Family #1: Annual Net Income $100,000. By living on 1/2 of their income each year ($50,000), and saving the other 50K, this family can save enough money to retire, regardless of their age, in seventeen years. This assumes an annual return of investment (ROI) of 5%, which is reasonable within an equity portfolio. It is based on an annual 4% 'safe withdrawal' rate upon retirement, which would be enough to cover their $50,000 living expenses.

-Family #2: Annual Net Income $60,000. By living on $30,000, and saving the remaining $30K, family #2 can also retire in 17 years, making the same assumptions of return, and safe withdrawal rate.

Of course, the family living on $30K has to make do with less.

That's where the frugality guru's come in.

Their message, of which I am a firm believer, is that by spending far less money on material possessions, families can afford to live on much lower income levels than society would have us believe. Furthermore, less money spent on things like luxury homes and fancy cars will lead to a happier, more stress free life. No more keeping up with the Joneses!

Financial Independence sounds pretty nice!
However, if you're struggling just to make your payments, it's hard to imagine living on 70% of your income, let alone 50%!

Herein lies the silver lining. There's a good chance you already are.

To illustrate, let's create a scenario of a family with a $5000 monthly income, and a very heavy debt load:

This family, let's call them the Joneses, have a loan on a fancy new pick up truck and are also making payments on a couple of credit cards. They have a revolving line of credit balance that never seems to do just that, as well as a fairly significant consolidation loan. This is left over from the last time they tried to get their finances under control. Oh, and there's the long-term loan for the 30-foot travel trailer. That is why they bought the truck, after all.

Because of all these payments, the Joneses can only manage to set aside $200 for long term savings, and even that feels like a stretch!

(For this illustration, we won't include housing costs, just consumer debt).

To summarize, after removing savings and debt payments from the equation, the Joneses really ARE living off of 66% of their income. It may not be their choice, but they've found a way to make it happen.

Now for the opportunity.
If the Joneses are willing to make the lifestyle sacrifices necessary to pay off their consumer debt, and transfer the money spent on monthly debt payments directly into savings, they would create an immediate 34% savings rate!Every Cloud

We haven't even taken into account the money they may be able to save
on other expenses such as their mortgage, groceries or dining out. There's also fuel and other conveniences such as smartphones, cable, subscriptions etc.

It's very possible that they could in due time they could move the 34% savings rate closer to 40%, or even 50%!

Think about your situation.
You may not have the debt load the Joneses have, but you may feel as though you're unable to save nearly enough to someday achieve financial independence.

Try the same exercise.

Total up the payments you are making towards your consumer debt. Now imagine transferring all of this cashflow directly towards savings as soon as you've paid the debt.

To me, the thought is incredibly motivating, it's the silver lining. There is one caveat however:

1. Mortgage Payments

If you’re low on cash one month, it might be tempting to make your mortgage payment with a credit card with a high credit limit. But, there are problems with this thinking.

For one, some mortgage companies won’t let you make direct payments with a credit card. Although there are third-party companies that will help you use your credit card to pay your mortgage, they often also charge fees for this convenience — which will just add to the amount you’re paying in bills each month.

Should you be able to circumvent your mortgage servicer and find a way to pay your mortgage with a credit card, it’s still a bad idea if you don’t plan on paying off your credit card balance in full each month: You’re already being charged interest on your mortgage, so why add more interest to the amount you’re putting on your credit card balance?

And lastly, charging a large amount to your credit card will lower the amount of credit available to you, which could lower your credit score.

2. Small Indulgences

Sure, it’s sometimes more convenient to whip out the credit whenever you buy a cup of coffee, a sandwich at the deli or a new pair of $5 earrings. And sometimes, depending on the cash-back credit card or rewards credit card you use, you’re even rewarded for those small purchases with cash or points.

But if you swipe your credit card for every small purchase, your credit card balance could grow out of control. And the higher your balance, the harder it will be to pay off and afford the minimum payment. At the end of the month, you’ll be left wondering, “Were those 20 lattes really worth it?” Plus, sometimes store owners will charge you a fee if you use your credit card to purchase items under a certain amount of money.

Instead of using your credit card to pay for small, discretionary items, consider using cash. Not only will it save you from running up your balance, but it’ll help you stick to a budget. Think about it: If your card has a credit limit of, say, $5,000, that’s basically $5,000 worth of coffee you could potentially buy with your credit card. But by allowing yourself to only use $20 in cash per week for all small purchases, you’ll likely spend less.

However, if you don’t want to miss out on credit card rewards points or cash-back opportunities, consider getting a debit card that offers similar rewards. With a debit card, the money will be automatically taken from your account, so you won’t have to pay interest. Plus, it’s another easy way to stay on budget.

3. Cash Advances

A cash advance is a withdrawal or a short-term loan where you’re borrowing against your credit card account. If possible, avoid taking a credit card cash advance — or else you might be faced with high fees and interest rates. Your APR and fees will vary depending on your bank and credit card issuer, but, in general, the APR on a cash advance is higher than a purchase APR.

For example, you might have a credit card that charges a purchase APR of 11.00% or 12.00%. However, the APR for cash advances might be 2 or 3 percentage points higher. And, your fees might equal $10 or a small percentage of each transaction — whichever is greater. This is why many personal finance experts and blogs highly discourage getting a cash advance from your credit card.

4. Household Bills

There are some strong arguments of why it’s a good idea to put household bills — such as utilities — on a credit card. Your department of water and power, for example, might let you use a credit card to pay your bills without being charged a fee for the service. So, if you belong to a credit card rewards program, you might be tempted to link your credit card to the account to rack up those rewards points. And if your servicer lets you set up automatic payments with a credit card, that’s one less bill you don’t have to remember to pay on time.

Still, relying on credit cards to pay too many of your household bills could get you in financial trouble, especially if you have a bad habit of checking your credit card balance. Without regularly checking your balance and making sure you pay off your credit card in time, you might miss a credit card payment and get hit with interest charges.

A better idea might be to link your debit card instead. But again, make sure you regularly watch your checking account. Otherwise, your balance might fall into the negatives if you don’t transfer enough money into your account to cover all of your household bills.

5. Medical Bills

When you don’t have enough cash on hand or in your checking account to pay for medical bills, one of the worst things that you can do to your current and future finances is put them on your credit card. Medical care is expensive, and paying for it with a credit card that will charge you high interest on top of this is could be a bad idea.

If you have large medical bills that you can’t pay immediately, don’t automatically whip out your credit card. Instead, contact the hospital’s financial officers and see if you can set up a payment plan. Chances are, you will be paying much less in interest to the hospital than your credit card issuer will charge you.

6. College Tuition

College tuition is expensive. In fact, it might outweigh the cost of living, depending on where you reside. If you’re a broke college student, it can be very convenient to use your credit card to pay that tuition bill. But think twice before you do.

The best reason not to do this is because you might not be able to pay off your credit card before you have to start paying interest on it. Plus, many schools will tack on a convenience fee of 2 percent or even 3 percent for the “privilege” of paying your tuition with a credit card.

Bottom line: It’s not worth it. If you’re having trouble making your tuition payments on time, talk to your adviser or someone at the financial aid office at your school. They’ll fill you in on the types of low-interest student loans, grants, scholarships or work-study programs available to you to help pay your education costs.

7. Your Taxes

While it’s possible — and perfectly legal — to pay your debt to Uncle Sam with a credit card, there is an excellent reason why you shouldn’t: Your tax processor will likely charge you a convenience fee of around 2 percent for using a card. If you’re only on the hook for a tax payment of several hundred dollars, that fee won’t amount to much. On the other hand, if you owe Uncle Sam thousands of dollars, that 2 percent fee can really add up.

The IRS currently lists fees that are valid through Dec. 31, 2016; they vary depending on your payment processor. If you use a debit card to pay your taxes via Pay1040.com, the IRS states you’ll be charged a $2.59 flat fee. But if you use a credit card, the fee jumps to 1.87 percent, with a minimum fee of $2.59. Meanwhile, paying with a debit credit via PayUSAtax.com requires a $2.69 flat fee; using a credit card will incur a 1.99 percent fee, with a minimum fee of $2.69.

8. Automobiles

Think this is a crazy idea? Some people claim to have used a credit card to pay for a car — and they don’t regret it, partially because they earned tons of points after doing so. In addition, a 2009 Consumer Reports article advises that you pay your car down payment with a credit card because if the auto dealer goes out of a business, you can challenge the payment with your credit card issuer.

Still, don’t resort to this payment method unless you’re confident you can afford it and the possibly high credit card interest charges. If you have a budget in place, using a credit card might be a viable option. But if you don’t have enough money for a down payment, perhaps you should delay your car purchase. Ask a financial advisor and speak with the car dealership first to make sure they’ll accept your credit card payment.

9. Down Payments of Any Kind

While on the subject, you might want to think twice before you use a credit card for a down payment on anything, including a house or a car. For one, you can’t typically use a credit card to pay your house down payment. You can, however, use it to get a cash advance to pay for it — but that’s not a good idea.

If the only reason you want to use a credit card for a down payment is because you can take advantage of your card’s high credit limit, that might be a sign that you can’t really afford the down payment. And if you don’t have the money for the down payment on a loan, don’t get the loan. Otherwise, you’re just adding a large cost to the sales price of your item — the high interest rates of a credit card.

Also, it’s important to consider the impact a large purchase — such as a down payment — on your credit card might have on your credit score. If your credit card balance is too high in comparison to your credit limit, your credit score might suffer. The same is true if you miss payments because you lose control of your account balance.

10. Your Business Startup Expenses

Perhaps you want to start a business but you need financing for startup costs — where do you turn?

Using your personal credit card to pay for business expenses can be a bad idea. It generally takes at least several years for a business to become profitable, and in the meantime, you might be paying extraordinarily high interest on debt that you cannot afford to pay back immediately. And if your business fails, you might be in deep credit card debt.

Sure, there are some upsides to using a credit card for business expenses. But if you do need to borrow a lot of money to kick off your business, you might be better off with a small business loan. Interest rates on credit cards are typically higher than rates on traditional loans, according to Entrepreneur.com. Even better: See if you can get raise money through a crowdfunding website or through friends and family.